Opinion

Felix Salmon

The unintended consequences of cheaper remittances

Felix Salmon
Mar 5, 2014 02:02 UTC

Once upon a time, remittances, especially to Mexico, were the next big thing. In 2002, for instance, Bank of America bought 24.9% of one of Mexico’s big three banks, Serfín, mainly for the remittance business:

Bank of America says it will compete with Citigroup for Mexican and Mexican-American customers in the United States. It particularly hopes to win a larger share of fees from the $10 billion in remittances they send to Mexico each year…

Kenneth D. Lewis, Bank of America’s chairman and chief executive, made it clear today that a primary goal of the deal was to gain more Mexican-American customers in the United States and ”dramatically increase our market share” of their remittances.

BofA’s purchase was in large part a defensive move — a reaction to the 2001 acquisition of Mexico’s largest bank, Banamex, by Citigroup. That deal, too, had a significant remittances component to it, and by 2004 Citi and Banamex had launched their Access Account, a product allowing Mexicans to easily send money from any Citibank branch in the US to any Banamex branch in Mexico.

The Access Account competed against a consortium of Mexican savings banks, who had teamed up with US Bank to create a similar product in 2003. But that wasn’t the end of the dealmaking: later in 2004, the third big Mexican bank, BBVA Bancomer, bought Texas bank Laredo National Bancshares for $850 million, with the aim of increasing Bancomer’s 40% share of the remittance business.

The banks were racing into the remittance market because it held a huge amount of promise: it was growing fast, the incumbents (Western Union and MoneyGram) were easy to undercut, and the potential profits were huge: after all, to a big bank, the marginal cost of moving money from the US to Mexico is essentially zero.

The promise of cheaper, next-generation remittances was so great that the World Bank, in 2009, set what it called a “5X5 Objective”: that it would reduce the cost of remittances by five percentage points in five years. By 2014, remittances would cost only 5%, rather than the 10% prevailing in 2009.

The objective was entirely achievable — and indeed, last year, looking at the depressed MoneyGram share price, I blithely declared that “money transfer is in the process of being disrupted”.

Certainly the growth in remittances, over the past five years, would more than allow for economies of scale. While international capital flows have fluctuated, remittances have been growing steadily, and have remained above all debt and portfolio equity flows every year since the financial crisis. Here’s the flows chart, from the World Bank:

Screen Shot 2014-03-04 at 7.48.07 PM.png

But here’s the chart showing whether the 5X5 objective is going to be met — and it’s not pretty. The reduction to an average cost of 5% isn’t even close to being achieved.

 

Screen Shot 2014-03-04 at 7.50.41 PM.png

In Mexico, remittance flows are falling, up even as the number of migrant workers in the US now comfortably exceeds the levels seen before the financial crisis. And the banks, who were once so excited about this market, are packing up shop:

Banamex USA underwent a downsizing last year. The company had a sizable business in taking money from third-party agents in the United States and then remitting the money back to an extensive network of Banamex bank branches in Mexico, industry experts say.

But now Banamex USA will transfer money from the United States to Mexico only from its own customers, a spokeswoman said. Last year, Banamex USA also reduced the number of its branches in California, Arizona and Texas, three states with large Mexican immigrant communities, to three from 11.

Citigroup said the changes at Banamex USA are part of the bank’s global restructuring of branches and businesses. But industry participants suspect that the moves may have more to do with avoiding the costs and risks of trying to meet anti-money-laundering regulations.

The problem with remittances, it turns out, is that such operations have a habit of getting hit by anti money laundering probes. The current problems at Banamex, for instance, come in the wake of similar issues at Western Union, which stopped using thousands of agents in Mexico who couldn’t meet regulatory-reporting requirements. On top of that, because there’s no shortage of smaller companies trying to compete on price, busy corridors like US-Mexico are now actually pretty cheap: the World Bank’s Dilip Ratha told the NYT last year that the cost of a $300 transfer is now only around 2%.

Indeed, if you look at the World Bank report, a curious phenomenon emerges: remittances seem to be growing fastest where they’re most expensive, and falling where they’re relatively cheap.

What this says to me is that if the World Bank wants to maximize remittance flows, maybe concentrating on bringing the price down is not the best way of doing that. Financial services to the poor are nearly always expensive, and the rich tend to have a very understandable and predictable reaction when they see that: they want to bring the price down, for the sake of the poor people. All too often, when that happens, the supply of that service tends to dry up — or the poor continue to pay more than they strictly need to.

Here’s a theory: when the cost of remittances is high, the providers of those remittances have every incentive to make it as easy as possible for as many people as possible to remit as much money as possible back home. And when the cost of remittances falls, those incentives weaken, and it’s easier to sever ties to merchants and generally discourage the use of services which you formally pushed aggressively. Maybe remittance services are sold, just as much as they are simply purchased. As a result, when they’re cheaper, and not sold as hard, the migrants end up spending more money where it’s earned, and sending less back home.

Most of the new companies competing on price against Western Union are doing so with mobile apps and the like: they try to make it as easy to send money home as possible. Maybe it’s as easy as just pressing a few buttons on your phone. But I suspect that what such services are not doing is adding much in the way of behavioral layers: they’re not giving people an incentive to send as much money home today as they possibly can. After all, if it’s that cheap and easy, why not send less today, and then more tomorrow, if it’s still there?

There are still a lot of areas of the world where the cost of remittances is too high, of course. But when it comes to Mexico flows, I don’t think that’s necessarily the problem. Not any more, anyway. Instead, if anything, the cost of remittances might be too low: it doesn’t give banks an incentive to be active participants, given (a) the headaches involved with respect to money-laundering regulations, and (b) the up-front cost of enticing migrants to use the service in the first place. So the banks will keep the product in place — they just won’t make it particularly easy to use, and they won’t promote it aggressively. And they won’t be too upset if usage declines.

Update: Timothy Ogen replies.

COMMENT

I wonder if banks are going to find themselves bypassed when remitters use bitcoin (et al).

Posted by markhahn | Report as abusive

Why Puerto Rico’s bonds are moving to New York

Felix Salmon
Mar 3, 2014 20:07 UTC

Puerto Rico, which is already junk-rated and which is facing yet another downgrade to its credit rating, is in no position to call any shots when it comes to raising new debt. If it wants to borrow new money — and it looks like it wants to borrow a hefty $3.5 billion in the next few weeks — then it’s going to have to make whatever concessions its lenders want. That means paying a very hefty interest rate in the 10% range, of course. But it also means changing the governing law of the bonds, from Puerto Rico to New York.

Notably, the Puerto Rican government was very careful to ensure that it would not waive its sovereign immunity, except as regards “legal proceedings with respect to such bonds”. The result is that Puerto Rico seems, on its face, to be setting itself up for a nasty, drawn-out stalemate a la Argentina, where bondholders sue a sovereign nation in New York, trying to claim all the principal and past-due interest that they’re due, while the sovereign in question responds that all of its assets are immune from attachment. That’s definitely not the kind of fight that the hedge funds lending Puerto Rico money would ever want. So why are they insisting on New York law?

The answer is that the hedge funds lending to Puerto Rico basically look at bond contracts, and New York law, in much the same way that Argentina does. In fact, they would be very upset if Puerto Rico treated its new debt in the way that Argentina’s opponents — and a number of New York federal judges — like to think.

At stake, of course, is the fate of Puerto Rico’s bondholders if and when the territory ever defaults on its obligations. Already, some Puerto Rican lawmakers are saying that’s exactly what should happen, and there’s no obvious fiscal track to debt sustainability, so default is a very real risk, and the main thing that lenders want to protect themselves against.

Historically, default protection has come mainly in the form of asset-backed bonds. Most of Puerto Rico’s debt is backed by some revenue stream or other: even if the government defaults, the state-owned utilities and the like will still have revenues which can be attached (at least in theory) by bondholders. But here’s the problem: if I held one of those revenue bonds today, I would not feel particularly confident in my ability to continue to get my coupon payments, even in the face of a government default.

The problem is precisely that so much of Puerto Rico’s debt is collateralized in this way. If we reach the point at which Puerto Rico needs to default in order to get its fiscal house in order, then it will have to restructure (which is to say, default on) its revenue bonds. If those are untouched, then the problem doesn’t get solved, and there’s really no point in defaulting in the first place. No one knows exactly how Puerto Rico would do such a thing, but legislation would probably be involved — if Greece can do it, then there’s a decent chance that Puerto Rico can, too. The idea is to pass a law which, in effect, makes it legal to default on your debts. And since those debts are issued under domestic law, there might not be much that bondholders can do about it.

Conversely, if Puerto Rico defaults with a relatively small quantity of New York-law debt outstanding, it’s probably easier for Puerto Rico to just continue to pay the coupons on that debt, rather than try to restructure it. Again, Greece is the precedent here: while debt under Athens law was restructured, debt under London law continues to be paid in full. Puerto Rico could default on its New York-law debt, of course — but doing so would severely cripple the island’s ability to do business with the mainland; would involve paying massive legal fees for years to come; and probably wouldn’t move the needle very much when it came to debt sustainability.

The point here is that the concept of seniority doesn’t really make a lot of sense when you’re not operating in the context of a formal bankruptcy regime. A bankruptcy judge can ensure that a debtor pays senior creditors first, and junior creditors last. But in a sovereign context — which includes Puerto Rico — there is no such thing as bankruptcy. In the Argentina case, the New York courts are trying to enforce an idiosyncratic reading of the formerly-obscure pari passu clause to try to bring back some semblance of seniority into the sovereign debt world, but it’s a knock-down, drag-out fight, and no one knows how it’s going to end. The overarching principle in sovereign debt remains the principle that has governed Argentina’s behavior ever since it defaulted well over a decade ago: a sovereign government can and will pay whomever it likes, whenever it likes, wherever those people think that they might stand in terms of some theoretical seniority chart.

As a result, creditors in Puerto Rico aren’t looking for de jure seniority; they’re looking instead for de facto seniority. And the way to get that is to be part of a small group of bonds which is more trouble than it’s worth to restructure.

That strategy generally works very well. When most of Latin America was busy defaulting on its sovereign loans in the 1980s, for instance, the countries in question generally stayed current on their sovereign bonds — just because the loan stock was big, and mattered, while the bond stock was small, and didn’t. Similarly, when Russia defaulted on its debt in the late 1990s, it defaulted on its large stock of domestic bonds, but stayed current on its much smaller stock of international-law bonds, for exactly the same reason.

So when you see hedge funds demanding that their new Puerto Rico bonds be issued under New York law, don’t kid yourself that they particularly value the protections that New York law gives them, or that they think that New York courts will allow them to recover most of their money in the event of default. Rather, they’re just hoping that Puerto Rico won’t bother defaulting on those bonds in the first place. And they might well be right about that.

COMMENT

It is in PR’s interest to not only default but also to repudiate. When it happens, all holders will be offered the same deal, such a bond worth ten or twenty cents on the dollar, a long maturity and a low interest rate. Puerto Rico is just another over-indebted Latin American country.

Posted by nixonfan | Report as abusive

Incompetent Banamex

Felix Salmon
Feb 28, 2014 22:28 UTC

A couple of weeks ago, I was at a lunch discussion of immigration policy, of all things, in which I defended Citigroup’s decision to move various risk-management operations from New York to Mexico. I was talking to a woman who was complaining about the move and about the amount of time that the Mexico office would sometimes take before arriving at a decision. But my view was that moving such operations to Mexico was probably a good thing, on net. After all, Citi’s Mexican bank — Banamex — is one of the most efficient banks in the Americas, and makes a lot of money while taking very little in the way of risk. And on the other side of the trade, the New York office was precisely the place where Citi’s risk management was worst. After all, it was New York which missed the entire subprime problem, along with many other incidents in which Citi managed to blow itself up.

Now, however, it seems that Banamex has a level of risk management which is bad even by Citi standards. Earlier this week a Reuters report showed how Banamex managed to lose some $85 million making bad loans to homebuilders, despite opposition from the head office:

The $300 million in loans were made starting in 2009. Bank executives at Citigroup in New York turned down at least some of the business because it seemed too risky, two sources involved with the lending process said…

New York balked, but the bank’s Mexican subsidiary, Banco Nacional de Mexico, better known as “Banamex,” went ahead and lent to the homebuilders. Banamex, which is the second biggest bank in Mexico with 1,700 branches, has room to make some loans that do not get vetted by New York, as long as its overall portfolio is safe enough, the sources said.

“New York turned them down because they made no sense,” said one of the sources, referring to loan applications by Mexican homebuilders at the time.

Today, things got much worse: it turns out that Citigroup has had to write off some $400 million of what were previously thought to be perfectly safe loans to an oil services company called Oceanografia.

The Oceanografia loans, which totaled $585 million at the end of last year, were ostensibly simple advances against Pemex receivables. The state-owned Mexican oil giant can be slow, so if you’re owed money by Pemex, and need a bit of liquidity, you can essentially sell your receivables to Banamex. The problem is that Banamex seems to have bought a large number of fake pieces of paper:

Citi estimates that it is able to support the validity of approximately $185 million of the $585 million of accounts receivables owed to Banamex by Pemex as of December 31, 2013. This $185 million consists of approximately $75 million supported by documentation in Pemex records and approximately $110 million of documented work performed that was still going through the Pemex approval process.

There are two huge failures here. The first was in the accounts receivable department, where Citi employees, through incompetence or venality, failed to ensure that the assets they were lending against were real. The second is higher up, in the bigger Banamex and Citigroup risk-management departments, where no one seems to have stopped to ask how on earth a simple accounts-receivable credit line could have grown to more than half a billion dollars in size. After all, Pemex might be slow, and it might be big, but it’s not so slow and so big that it’s likely to owe a single vendor $585 million just in simple unpaid invoices which are wending their way through its bureaucracy. As Matt Levine says:

This went on for years? That to me is the oddest part. Oceanografia is — somewhat obviously — not a public company, but a random assortment of pseudo-comps suggest that typical accounts receivable turnover in the oil-services industry averages around three months. One imagines that Pemex gets more breathing room than the average customer, but still, at some point, wouldn’t Banamex call Oceanografia after not getting paid for a year or two? Did Oceanografia just say “yeah, I know, what jerks, they’re really slow, keep trying”? And Banamex kept extending more credit on more fake receivables, to a total amount of $585 million? And never called Pemex?

This explains why Citi CEO Mike Corbat is saying that “all will be held equally responsible” in this affair: the risk managers who let this one through the cracks just as much as outright criminals who (maybe) accepted kickbacks to look the other way. In a bank the size of Citi, you can’t just assume that all your employees are excellent, law-abiding folk who will catch any attempt to get around the rules: you need protocols that ensure massive frauds simply can’t happen, even in the face of employee misconduct or idiocy.

One big question raised by this loss — and the mortgage problems, too — is what they mean for legendary Banamex chief Manuel Medina-Mora, a man who almost became Citi’s CEO. Medina-Mora is in charge not only of Banamex, these days, but also the entire global consumer bank — Citibank, as it’s known everywhere except for Mexico. There are two possibilities: either, on the one hand, Medina-Mora has simply been stretched too thin, and was forced to take his eye off the Mexican ball. Or, on the other hand, Medina-Mora made his name and his reputation by loaning enormous amounts of money to large Mexican companies, be they homebuilders or oil-services vendors, and that was a strategy which was bound to blow up in his face eventually.

Citibank has a deserved reputation for consistently making bad loans — few banks have failed more often, or more spectacularly. The latest problems in Mexico are manageable even by Mexico’s own standards, let alone by the standards of the parent company. But they do show that Citi still hasn’t managed to get its risk controls nailed down. Probably, it never will: it’s just too big. Which means that this kind of thing is going to continue to happen, not only at Citi, but also at every other commercial lender of its size.

COMMENT

Felix

“Which means that this kind of thing is going to continue to happen, not only at Citi, but also at every other commercial lender of its size”

Including HSBC? http://www.financialtransparency.org/201 2/12/13/why-the-u-s-absolutely-should-ha ve-prosecuted-people-at-hsbc/

Posted by crocodilechuck | Report as abusive

Can bitcoin capitalize on the death of Mt Gox?

Felix Salmon
Feb 26, 2014 18:33 UTC

In November, I said that I was waiting for bitcoin to get boring – and it certainly isn’t boring yet. The death of Mt Gox has created headlines saying things like “Bitcoin future in doubt” and “Mt. Gox Meltdown Spells Doom for Bitcoin”; those, in turn, have sparked their own backlash of people saying that in fact this development is one of the best things that could have happened to the cryptocurrency.

The truth of the matter is that it’s too early to tell. Mt Gox was a unique institution in the bitcoin universe: it was there from the beginning, and people have been moaning about it from the beginning. It was always a badly-run and far too opaque institution; if bitcoin is ever going to really take off — if Ben Horowitz is going to win his socks – then the death of Mt Gox was surely necessary sooner or later. At the same time, however, Mt Gox was for many years the cleanest dirty shirt in the bitcoinverse, and historically accounted for the lion’s share of trading in the currency. That’s one of the reasons why it somehow managed to be sitting on such an enormous lode of bitcoins at the time it went belly-up.

The rumor is that 744,408 bitcoins are “missing due to malleability-related theft which went unnoticed for several years”; that’s hundreds of millions of dollars that have been stolen, and it’s almost impossible to believe that Mt Gox was so incompetent as to not be aware, for years, of a nine-figure hole on its balance sheet. Instead, it quietly sold itself not only as a trading venue but also as a wallet service: store your bitcoins with us, they’re safe here. So long as the number of people using Mt Gox as a wallet was greater than the number of bitcoins that had been stolen, the service could continue. But then, when the run started, Mt Gox collapsed — inevitably — in a matter of days. It’s a Ponzi scheme, essentially — just one that looks like it was driven by theft rather than avarice.

The Mt Gox fiasco is literally an order of magnitude larger than the previous largest bitcoin scam, the theft in July 2011 of 78,739 coins from a wallet service called MyBitcoin. The Mt Gox implosion is on a massively larger scale than even the shutdown of Silk Road, where some 171,955 bitcoins disappeared. As a result, it’s fair to say that the end of Mt Gox is also the end of bitcoin as we have known it to date — a wild-west world of hackers and discussion forums and pseudonyms and Tor accounts and — as one highly-active page puts it — numerous “Heists, Thefts, Hacks, Scams, and Losses.”

Now, we enter the world of Bitcoin 2.0: an arena of well-capitalized companies with VC backing; of sober joint statements using terms like “trustworthy and responsible” and “comprehensive consumer protection.” Of course, all these promises have been made before, not least by Mt Gox itself; the big questions are whether (a) this time is different; and whether (b) this time will be seen to be different by a population that has — quite rationally — had little faith in bitcoin to date.

My tentative answers to those two questions are yes and no, respectively. I actually do believe Coinbase and other next-generation bitcoin companies when they say that they’re much more robust than their predecessors. But I don’t believe that regulators, and the public at large, will believe them. Bitcoin is based on mistrust, which makes it almost impossible for this circle to be squared. There is a small number of cryptogeeks who really love the paradox that they can trust the protocol precisely because they don’t need to trust any given institution. Regulators, it’s fair to say, tend not to be among them. And neither are normal people, who don’t understand the math behind bitcoin, and who have no real ability to secure their coins on their own, and who therefore need to be able to trust whatever institution they’re using to store their bitcoin-denominated wealth.

In order for the end of Mt Gox to be a blessing for bitcoin, we’re going to need to see an influx of new entrants into the asset class — people who never trusted Mt Gox, but who are happy to trust (say) Coinbase. The bitcoin faithful — who include the likes of the Winklevii and Barry Silbert, along with Ben Horowitz — will happily celebrate the end of Mt Gox and try to use it as a way to persuade the general public, and regulators, that the field is growing up and can be trusted. The big question is whether anybody is going to believe them. And so far, I’ve seen no evidence that’s happening. As far as the public is concerned, Mt Gox was bitcoin. Most of us who never bought any bitcoins in the first place feel as though we likely dodged a bullet. And we have no particular desire to enter that war zone now, even if it is marginally safer than it was before.

PHOTOS: Kolin Burges, a self-styled cryptocurrency trader and former software engineer from London, holds a placard to protest against Mt. Gox, in front of the building where the digital marketplace operator was formerly housed in Tokyo February 26, 2014. REUTERS/Toru Hanai 

A mock Bitcoin is displayed on a table in an illustration picture taken in Berlin January 7, 2014. REUTERS/Pawel Kopczynski 

COMMENT

I’ve come to believe that a cryptocurrency that is designed to include a central bank, in which the size of the “mining” transaction in each new block could be adjusted through broadcast software updates from the central bank, might actually have some viability. Under this system, the central bank would have control over the rate of money supply growth. You could also tweak things so that the mining transaction was required to make deposits to two wallets — one belonging to the mining collective, for distribution to their members who contribute computational power to help process transactions; and one to the wallet of the central bank itself, thus retaining some of the value of seigniorage. You’d probably want to have some kind of system for rotating through central bank wallets, so that you weren’t accumulating too much value in one place. Maybe the bank would broadcast a new wallet ID every week or so, and would empty out the old wallet on a regular basis.

I still think there could be problems with scaling the volume of transactions in a way that doesn’t risk frequent forks in the blockchain.

One way to process more transactions is to make it easier to find a valid block (put looser constraints on a valid hash). Go too far in this direction, and you’ll hit a point where the first valid block can’t spread to the full network fast enough to become entrenched before an alternative valid block is found. The system can cope with this if it doesn’t happen often, and doesn’t tend to result in subsequent blocks getting attached on both sides of the fork before the fork is resolved. Speed is the enemy of stability.

The other way would be to simply include more transactions in each block, but it seems like this could be a serious problem if you tried to scale existing bitcoin volumes up to the kind of volume that exists in dollars today — several orders of magnitude. It’s not clear to me what kind of pressure this would put on mining hardware.

There’s also the fact that if quantum computing ever solves the problem of testing many hashes at once, whoever owns the first computer that can do that will instantly be able to compromise the entire cryptocurrency system. But they would probably pose a non-trivial threat to existing networked banking systems too. :-P

Posted by Auros | Report as abusive

The bank tax rises from the dead

Felix Salmon
Feb 26, 2014 06:05 UTC

Back in January 2010, Barack Obama — flanked by Tim Geithner, Larry Summers, and Peter Orszag — unveiled a new tax on big banks, or a “financial crisis responsibility fee”, as he liked to call it. Of course, this being Washington, the initiative never got off the ground, and was largely forgotten — until now:

The biggest U.S. banks and insurance companies would have to pay a quarterly 3.5 basis-point tax on assets exceeding $500 billion under a plan to be unveiled this week by the top Republican tax writer in Congress.

This doesn’t mean the tax is likely to actually see the light of day, of course — but the fact that it has some kind of Republican support has surely breathed new life into a proposal that most of us thought was long dead. After all, the initial proposal was designed around the idea that the tax would allow the government to be repaid for the cost of the TARP program — a goal which has now pretty much been met.

There are some interesting differences between the Obama tax of 2010 and the Dave Camp plan of 2014. The Obama tax was on liabilities; it specifically excluded deposits (which already have a sort-of tax associated with them, in the form of FDIC insurance); and it would have been levied on all financial institutions with more than $50 billion in assets. It was set at 0.15%, and was designed to raise $90 billion over ten years.

The Camp tax, by contrast, is on assets, which means that deposits sort-of get taxed twice; but that means it can also be set much lower, and the size cap be raised much higher, while still raising the same amount of money. Camp’s tax is a mere 0.035%, and is applied only to assets over half a trillion dollars. It’s designed to raise $86 billion over ten years — although, confusingly, the Bloomberg article also says that “it would raise $27 billion more over a decade than the president’s plan would”.

I like the simplicity of the Camp plan, although I would have preferred to tax liabilities rather than assets. After all, it’s not size that’s the real problem, it’s leverage, and it’s always good to give banks an incentive to raise more capital and less debt.

I like the way that it’s targeted: just ten US institutions would account for 100% of the revenues from the tax. The list in full: JPMorgan; Bank of America; Citigroup; Wells Fargo; Goldman Sachs; Morgan Stanley; GE Capital; MetLife; AIG; and Prudential. None of them need to be as big as they are, and between them they’re more than capable of coming up with $9 billion a year to help make up for the fact that they each pose a huge systemic risk to the US economy.

At heart, this is a Pigovian tax on something (too-big-to-fail financial institutions) we don’t want, and often Pigovian taxes are more effective than regulation when it comes to minimizing such things. What’s more, it’s sharp enough to hurt: JPMorgan, for instance, would have ended up paying about 15% of its 2013 net income in this one tax alone.

For exactly that reason, however, I’m still skeptical that the tax will ever actually arrive. Those ten institutions are extremely powerful, and are more than capable of persuading politicians on both sides of the aisle to vote against a tax which singles them out for pecuniary punishment. The tax was a good idea in 2010, and it’s a good idea today. But it has very little chance of ever becoming a reality.

COMMENT

Isn’t 3.5bp/quarter pretty much the same rate as 15bp/year?

Posted by niveditas | Report as abusive

It’s time for Bill Gross to retire

Felix Salmon
Feb 25, 2014 07:24 UTC

A word of entirely unnecessary advice for anybody on the Pimco trading floor Tuesday morning: do not look Bill Gross in the eye. Or talk. Or do anything at all to make yourself stand out or be noticed. Because Gross, who for most of his career has been the subject of some of the most glowing press imaginable, has just been brought down by a downright brutal article on the front page of the WSJ. Neither Gross nor Pimco will ever be seen the same way again, and indeed, if Gross cares at all about the long-term fortunes of the company he built, the best thing he can do right now is simply retire.

The story is illustrated, online at least, with a gruesome photograph of the 69-year-old money manager, looking sideways through yellowing eyes as he reaches out like something from a zombie movie. And it just gets worse from there, confirming all the worst fears of anybody with investments at the monster-sized firm.

Late last year, in front of a number of traders, Mr. Gross said, “if only Mohamed would let me, I could run all the $2 trillion myself…I’m Secretariat,” referring to the famed thoroughbred. “Why would you bet on anyone other than Secretariat?”

That’s just about the worst possible thing for Gross to be quoted saying, given who Pimco’s clients are, and what they want, and what former CEO Mohamed El-Erian has been telling them, consistently, since he re-joined the company in 2007.

Pimco’s clients are, overwhelmingly, fixed-income investors. That means they’re conservative: while they like outperformance, they’re not shooting for the stars, and they hate taking unnecessary risks. Like, for instance, the risk that they’ve placed their billions in the hands of a cantankerous old man who always thinks that he’s right and that everybody else is wrong.

“I have a 41-year track record of investing excellence,” Mr. Gross told Mr. El-Erian, according to the two witnesses. “What do you have?” …

When Mr. Gross establishes an investment thesis, he usually doesn’t appreciate dissenting views, employees and former Pimco traders say. Once, when a senior investment manager said a bond in Mr. Gross’s fund appeared to be expensive, Mr. Gross responded: “OK, buy me more of it,” according to a Pimco executive. The purchase was made…

Mr. Gross said in a recent interview that he would be stepping back from some investment duties, but others at the firm are skeptical he will give up any control.

“I’m ready to go for another 40 years!” Mr. Gross posted on Twitter after Mr. El-Erian’s departure.

Pimco’s investors are also overwhelmingly institutions. Pimco itself gets mandates not because it has the best performance, but more because it’s the ultra-safe choice: it can pass any conceivable due diligence test, it has been around for decades, and it has multiple layers of checks and balances. El-Erian knew exactly what his job was, in public and in private: to paint Pimco as a disciplined supertanker of an investment vehicle, with committees and open dissent and a well-tested procedure for arriving at investment decisions, which was much more robust and much more trustworthy than any individual could ever be. In other words, to move Pimco (or at least the 90% of Pimco which isn’t Gross’s Total Return Fund) as far as possible from idiosyncratic Bill Gross risk as possible. Gross is old, he’s erratic, and he’s generally not someone you want to park your money with on the quasi-permanent time horizon which is used by Pimco clients like sovereign wealth funds and foundations.

Today, with the publication of this article, every fear of every large Pimco investor is going to be rearing its ugly head. Now that El-Erian has left, are Pimco’s trillions effectively under the sole charge of a monomaniac? Indeed, it seems that Gross has become so impossible to work with that El-Erian — the man who repeatedly said that he loved his job, the man who even according to this article “flourished in the firm’s demanding environment”, the man who was the explicit heir apparent to Gross — ended up resigning rather than work for Gross one more day.

“I’m tired of cleaning up your shit,” El-Erian said to Gross, last June, in front of more than a dozen colleagues. El-Erian is soft-spoken to a fault; if Gross had pushed him that far, it’s little surprise he quit.

Note too the byline on the article: it’s by Gregory Zuckerman, a man who has made a career out of writing awestruck books about the investing prowess of billionaires not unlike Gross. The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History, published in 2009, was followed up by The Frackers: The Outrageous Inside Story of the New Billionaire Wildcatters. Zuckerman’s stock in trade is not character assassination; quite the opposite. And yet he has penned what could — what should — be a fatal blow to the career of the greatest bond investor of all time.

There is no way for Gross to recover from this article. He knows it, too. When El-Erian first told Gross that he wanted to quit, Gross offered him “more power”, according to Zuckerman; indeed, El-Erian was offered “whatever he wanted to entice him to stay”. None of it was enough. El-Erian has said basically nothing in public since he quit, but the message here speaks loudly all the same: his job as CEO was to manage Pimco’s risks, and he felt simply incapable of managing the biggest risk of all.

Sometimes, the CEO isn’t really the CEO. When El-Erian was at Harvard, he “was having a heart attack” thanks to the irrational demands of Larry Summers, and ended up quitting to go somewhere a bit more grown-up. I can see how he would have had no desire to replay that movie a second time. And if El-Erian can’t manage Gross, then no one can manage Gross.

As a result, the only way to save Pimco is for Gross to leave the firm entirely. If he must, he can take his Total Return Fund with him. Pimco’s investors care about good governance ahead of anything else, and Pimco is clearly suffering under the very opposite of good governance right now. Gross is singlehandedly responsible for most of what Pimco is today, and he can leave, at this point, with his head held high. But his natural tenure at Pimco has come to an end. It’s time for Bill Gross to take his leave of the company he built, and for him to watch it thrive under more professional, less idiosyncratic, management.

Update: Matthew Klein responds with an argument which would be very strong, were Gross a stock investor rather than a bond investor:

Every investor has a choice between allocating their money to active money managers who bet on the markets, such as Gross, and handing over their savings to index-hugging mutual funds that charge rock-bottom fees.

Klein says, of Pimco’s funds, that “there simply isn’t an excuse for paying those kinds of fees unless you expect performance to materially differ from a standard buy-and-hold index.” Except, he never says what “those kinds of fees” are.

Klein makes two big mistakes, here. Firstly, he thinks that it’s possible for big institutional investors to simply pick a fixed-income benchmark and track it, at very low fees. It’s not. The S&P 500 is easy to invest in directly; the Barclays Agg is not.

Secondly, Klein thinks that Pimco’s fees, for its big institutional clients, are significantly higher than the “rock-bottom fees” you can find in a “buy-and-hold index”. Again, this is simply not true. You can’t buy-and-hold bonds: they constantly mature, and need to be reinvested in something new. Which is expensive, and non-trivial. Pimco and Blackrock, with their scale, can do that job more effectively than just about anybody else — which means that they can compete aggressively on fees against just about anybody else.

So not only is there no simple way of investing in bond indexes, even if there were such a way, it would not be significantly cheaper than most of the products being offered by Pimco. If you want to invest in bonds, you basically have to pick an active manager.

Investors have a choice between Pimco and its competitors, but they don’t really have a choice to pick “none of the above” and go with an entirely passive strategy. What’s more, if they did want an entirely passive strategy, and set up a fee scheme where any deviation from the benchmark would be punished, then I’m pretty sure that Pimco could provide them that product at a cheaper price than just about anybody else.

COMMENT

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Charts of the day, female risk-aversion edition

Felix Salmon
Feb 24, 2014 22:47 UTC

Catha Mullen of Personal Capital, an online wealth-management company, has an intriguing post about what she calls “gender bias in investing”. Looking at the Personal Capital user base, she found that “women are on average 7% more risk-averse than men”, and that “the effect of gender on risk tolerance is greater than that of any other variable” — bigger even than net worth.

Because Mullen’s multivariate analysis table is quite hard to read, I asked her to generate a couple of histograms for me. Here are the results:

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In both cases, risk tolerance is based on Personal Capital’s five-point scale, which runs from 1 (“Market volatility makes me very uncomfortable. Safety is a much higher priority than growth for me, and I do not expect growth meaningfully above inflation”) to 5 (“I am willing to take a high degree of risk in pursuit of higher returns, and am very comfortable with the volatility of a 100% stock portfolio”). I’ve also stripped out the data for people with net worth over $5 million, since the dataset there seemed to comprise one man and zero women.

Overall, calculates Mullen, women will end up with roughly 10% less money at retirement, thanks to their higher risk aversion. Maybe that explains why Warren Buffett, in his will, isn’t giving his wife cash, but instead is setting up a trust for her which is 90% invested in stocks. But I don’t think that Mullen’s findings counteract the generally-accepted fact that women are better investors than men.

The biggest story in these charts can be found at the far left, among the young and the relatively impecunious. If you’re a woman between the ages of 18 and 30, or if you’re a woman with a net worth of less than $100,000, then you’re a lot more risk-averse than a man in the same position.

This risk-aversion could well be entirely sensible. If you’re just saving for retirement, then it makes sense for younger and poorer people to maximize their risk appetite: you have relatively little to lose, while a nice gain early on can give you an unbeatable headstart later in life. But the fact is that most of these people are probably not saving for retirement: they have more urgent expenses to deal with first, like the costs involved in buying a house or raising a young family. In that case, it makes sense to be relatively risk-averse.

It’s also interesting that the richer men get, the closer they get to how a similarly-situated woman would invest. You’d think that risk tolerance would rise with net worth, but in fact it doesn’t: once you have a decent nest egg, it turns out, you start concentrating more on how to keep it and less on how to grow it. That’s one reason why Suze Orman puts nearly all of her money into wrapped and triple-A rated zero-coupon municipal bonds. She can live extremely well on what she already has, so the most important thing is to retain that wealth, rather than bear any risk that it’s going to disappear. (Interestingly, Nassim Taleb has a very similar investment portfolio, although he takes a lot more risk with the 10% of his money which he puts at risk.)

In general, people filling out investment questionnaires tend to overestimate their own risk appetites — which implies that men are taking too much risk, and that they’d be better off behaving more like women. A good investment advisor knows to invest her clients’ money more cautiously than they say they want; the lesson of Mullen’s data is probably that she should bring the risk down more for men than she should for women.

COMMENT

Felix, you’re not making much sense here:
“…the fact is that most of these people are probably not saving for retirement: they have more urgent expenses to deal with first..”: what does this have to do with gender differences, unless you think that women have disproportionately more urgent expenses? And if you do, you should at least write one sentence explaining why you think so.

Nor here:
“…people filling out investment questionnaires tend to overestimate their own risk appetites — which implies that men are taking too much risk, and that they’d be better off behaving more like women…”: again, on what basis are you asserting that men are more likely to overestimate their risk appetite than women?

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Felix Salmon smackdown watch, pensions edition

Felix Salmon
Feb 23, 2014 20:10 UTC

Many thanks to John Arnold for responding to my post about how he (and his foundation) should approach pension reform. We agree on many things, it turns out; but there’s one big area where we disagree, which is encapsulated most cleanly in the question of what exactly is going on in San Jose mayor Chuck Reed’s Pension Reform Act. I characterized Reed’s ballot initiative as “allowing governments to default on their pension obligations”, and “an attempt to renege on governments’ existing pension obligations”. Arnold says I’m entirely wrong about that:

Salmon repeatedly claims that my wife, Laura, and I and our foundation, LJAF, “support plans making it easier for governments to default on existing promises.” Nothing could be further from the truth. We strongly believe that pension reform should not aim to cut or eliminate benefits…

The initiative explicitly honors and guarantees the benefits earned for work done to date. The only question here is whether the employer and employees should be able to negotiate retirement compensation for work that is not yet performed. In other words, does an employee who was hired yesterday have the guaranteed right to earn pension benefits under the same formula for all future years of service? Under Reed’s proposal, cities in California could negotiate with employees, through the collective bargaining process, to change retirement compensation for future service just as they would do for salaries or health benefits. That change would have no effect whatsoever on benefits that have already been earned.

So, who’s right? In order to answer that question, it’s helpful to follow one of Arnold’s links, to a paper on teacher pensions which was put written by the Arnold Foundation’s Josh McGee. The paper addresses a serious problem: that “teachers accrue relatively meager benefits through much of their careers, and then abruptly become eligible for much more as they near retirement age”. For instance, here’s what happens for a teacher who enters the New York system at age 25, if you value pension wealth as the present value of your pension payments:

cr_79f2.gif

For the first decade, the teacher accrues essentially zero pension wealth, while the value of the pension rises in value by $101,667 in the two years between age 61 and age 63.

Other school systems have even more dramatic backloading. Here, for instance, are McGee’s charts for Miami and Las Vegas. Look at the darkest line, the one showing “pension wealth” over time. In Miami, that wealth can jump by some $250,000 in just one year; in Vegas, the jump is more than $300,000.

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So here’s the question. Put yourself in the position of someone who’s been teaching in Las Vegas for 29 years. The way that John Arnold sees things, over that time, you’ve managed to earn pension benefits worth roughly $200,000. If you teach for one more year, then the value of your pension benefits soars to more than $500,000: effectively, between salary and increased pension benefits, you’re being pad about $400,000 for that one year of teaching. Arnold wants school systems to “be able to negotiate retirement compensation for work that is not yet performed” — which is to say, to be able to pay you much less than $400,000 for that 30th year of teaching.

But that’s a very self-serving view of what’s going on in this pension scheme. Las Vegas teachers get their $500,000 package in return for 30 years of teaching, not in return for the 30th year of teaching. There’s a big difference. And it’s a difference that Arnold, for one, understands.

When a 25-year-old teacher joins the Las Vegas system, Arnold believes (and I agree with him) that the government should pay real money into its pension plan, in order to cover the actuarial costs that she’s going to qualify for in retirement. He doesn’t think that the government should drag its feet and wait until she’s 54 before it suddenly pays in an extra $350,000 or so: that’s not how pension plans work. Instead, they work by putting aside a certain amount of money every year, so that everybody in the system can receive, when they retire, the benefits guaranteed by the system. Indeed, when Arnold complains about pension plans being underfunded, what he means is that local governments aren’t putting enough money away to cover the sums which will be owed, in the future, to teachers who today are in their 20s or 30s. Those sums — and those funding shortfalls — are real, and substantial.

Arnold and I agree on what has been going on here: governments have promised juicy pension benefits in the future, in lieu of paying higher salaries in the present. Sometimes, they’ve failed to fully fund those benefits. But the promises are real.

Let’s make up some numbers for the sake of argument, and let’s ignore things like healthcare for the sake of simplification. Take a 25-year-old teacher on a salary of $50,000, where the government needs to make annual payments of another $9,000 per year in order to fully fund her pension. Effectively, what’s happened here is that the government and the unions have agreed on a total package worth $59,000 per year, of which $50,000 is salary and $9,000 is made up of pension promises. How much are those pension promises worth after ten years of service, in today’s dollars? The answer is about $125,000, if you assume the government’s investments grow at a real rate of 4% per year. The government has a liability to the teacher, which might be funded or might be unfunded, of roughly that amount. (In fact, the promise is worth more than $125,000, because of the effect of other teachers dropping out of the workforce before they reach ten years of service.)

If you ask Arnold, on the other hand, he’ll tell you that the teacher’s “benefits earned for work done to date” are basically zero — since if the teacher retired today, she would not be eligible for pretty much anything.

I disagree. I think that if the government has a liability — and Arnold is busy telling anybody who will listen that the government has a substantial liability, in this case — then the teacher has an equal and opposite asset. And it seems to me that the point of the Reed plan is to give the government the ability to take that liability, and — at least in the case of the teacher with ten years’ tenure — write it down to zero. Which would also have the effect of taking the teacher’s asset and writing it down to zero.

When you write down a future liability, you’re defaulting on your future obligations: that’s why I consider the Reed plan to be a means of reneging on existing promises.

Here’s another way of thinking about our hypothetical teacher: when she joins the school system, she’s granted a set of Restricted Pension Units, which vest over the course of 30 years. If she stays in the system until she’s 55, then those RPUs will be worth more than $500,000, in today’s money. But because of the way that money compounds, and because of the likelihood that she won’t stay in the system until she’s 55, the cost to the government of granting those RPUs, in year one, and also in any subsequent year, is only $9,000.

Nevertheless, those RPUs have been granted, and once granted, they belong to the teacher, not to the government. She can leave any time she likes, and leave most of her RPUs unvested. But that’s her choice, not the government’s. Unless the Reed initiative passes, in which case the government can essentially confiscate all of her unvested RPUs, and replace them with something else.

Now I agree with Arnold and McGee that there are better ways of designing pension plans, in a world where it’s not reasonable to expect teachers to stay in the same district for 30 years, and where it is reasonable to expect teachers with ten years’ service to have built up a meaningful retirement benefit, over the course of that decade, if they decide to move. I agree that if we were starting from scratch, we would design a plan which would look more like the grey upwardly-curving line in McGee’s charts, rather than the black back-loaded line.

But I disagree that if you’ve been teaching for ten years, then the pension promises that the government has made to you are, at this point, essentially worthless.

So here’s what I think should happen. First — and I agree with Arnold on this point — the government should make every effort to fully fund its existing and future obligations. Then, once those obligations are being fully funded, the government can start negotiating with the unions about ways in which to start offering choices to new teachers, and possibly even existing ones. If the government’s going to be spending $9,000 per year on your retirement benefits, where would you like that money to go? Would you like to join the existing defined-benefit plan? Or would you like to opt for something more like McGee’s smooth-accrual system?

The point is to ensure that everybody who has been promised something by the government has the right to demand that the government keep those promises. Not all governments keep all of their promises, but breaking promises is a serious thing: it’s called bankruptcy. We shouldn’t let cities and states get away with it by dint of a simple ballot initiative.

Update: John Arnold responds.

COMMENT

@BenWheeler, you have that very confused. The interest rate on munis is only relevant if the local government borrows the money to fund the pensions. If they FAIL to fund the pensions, then they are in essence borrowing from the pension fund at a rate equal to the assumed investment returns (typically 8%+). They are promising to cover a gap that is growing at that rate.

That exceptionally high implied interest rate is the reason why towns are floundering under this burden. What may originally have been a manageable obligation has doubled every 9 years (with continuing underfunding exacerbating the problem further). Carry that out over a few decades and you have a “debt” that is impossible to meet.

What they SHOULD do is float bonds to fund the pensions in full. The borrowing costs, as you observe, are much cheaper. And if the rating agencies complain about that, then perhaps they need to tighten their belt a bit? Hiding the obligations in underfunded pensions doesn’t make them any easier to afford.

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You won’t have broadband competition without regulation

Felix Salmon
Feb 21, 2014 17:03 UTC

Tyler Cowen isn’t worried about the cable companies’ broadband monopoly. His argument, in a nutshell: if you can’t afford broadband, that’s not the end of the world: you can always go to the public library, or order DVDs by mail from Netflix. And if the cable companies’ broadband price is very high, then that just increases the amount of money that alternative broadband providers can potentially make in this “extremely dynamic market sector”. Indeed, he says, if regulators were to force cable companies to decrease their prices, then that would only serve to decrease the amount of money that a competitor could make, and thereby lengthen the amount of time it will take “to reach a more competitive equilibrium”.

The first big thing that Cowen misses here is television. Cowen knows that there’s more to broadband than watching movies on Netflix, but what he doesn’t really grok is that there’s more to Netflix than watching movies on Netflix. Netflix has moved away from the movies model (which was a constraint of the DVDs-by-mail model) to a TV model. And that makes sense, because Americans really love their TV. They love it so much that cable-TV penetration is still substantially higher than broadband penetration. As a result, any new broadband company will not be competing against the standalone cost of broadband from the cable operators: instead, they will be competing against the marginal extra cost of broadband from the cable company, for people who already have — and won’t give up — their cable TV.

If you’re a cable-TV subscriber, the cost of upgrading to a double-play package of cable TV and broadband is actually very low; what’s more, there’s a certain amount of convenience involved in just dealing with one company for both services. The result is the barriers to entry, in the broadband market, are incredibly high. Cowen talks about pCells and Google Fiber, but really they prove my point: pCells are untested technology which would surely cost a mind-boggling amount of money to roll out nationally, while it’s taking even the mighty Google a huge amount of time and money to bring its own broadband service to a relatively small number of mid-size cities.

What’s more, all of that effort is redundant and duplicative: we already have perfectly adequate pipes running into our homes, capable of delivering enough broadband for nearly everybody’s purposes. Creating a massive parallel national network of new pipes (or pCells, or whatever) is, frankly, a waste of money. The economics of wholesale bandwidth are little-understood, but they’re also incredibly effective, and have created a system whereby the amount of bandwidth in the US is more than enough to meet the needs of all its inhabitants. What’s more, as demand increases, the supply of bandwidth quite naturally increases to meet it. What we don’t need is anybody spending hundreds of billions of dollars to build out a brand-new nationwide broadband network.

What we do need, on the other hand, is the ability of different companies to provide broadband services to America’s households. And here’s where the real problem lies: the cable companies own the cable pipes, and the regulators refuse to force them to allow anybody else to provide services over those pipes. This is called local loop unbundling, it’s the main reason for low broadband prices in Europe, and of course it’s vehemently opposed by the cable companies.

Local loop unbundling, in the broadband space, would be vastly more effective than waiting for some hugely expensive new technology to be built, nationally, in parallel to the existing internet infrastructure. The problem with Cowen’s dream is precisely the monopoly rents that the cable companies are currently extracting. If and when any new competitor arrives, the local monopolist has more room to cut prices and drive the competitor out of business than the newcomer has.

In other words, the market in delivering broadband to the home is pretty much the opposite of the international text-messaging market which was disrupted so effectively (and so profitably) by WhatsApp. The initial impetus for WhatsApp came in Europe, where lots of people want to communicate with their friends across borders: from Germany to Austria, say, or from the Netherlands to Belgium. Text messaging across borders is expensive, both to send and to receive, and WhatsApp used those phones’ existing internet connectivity to be able to provide a better service at a price of zero. Since the mobile operators weren’t willing to bring their international text-messaging prices down to zero, they simply lost tens of billions of dollars’ worth of text messages to WhatsApp and other internet-based messaging services.

In broadband, by contrast, it’s the cable operators who could, if they wanted to, bring the marginal cost of broadband down to zero. (There’s no reason, in principle, why they can’t provide broadband for free to anybody with a cable-TV subscription.) Meanwhile, any would-be disruptor, needing to repay a massive capital investment, is going to have less ability to slash prices than the incumbents do.

So don’t count on competition to bring down prices in the broadband space. This is an area where the regulators — and only the regulators — can really be effective.

COMMENT

Realist, I knew that number was ridiculously low, but I couldn’t let it go.

Still, $20 billion in capex for a telco with revenue of $128 billion is not special. And I would bet a disproportionate amount is spent on their LTE network. I doubt much is spent expanding their fiber footprint or upgrading their DSL service.

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